Wall Street is already celebrating the first rate hike in nearly a decade.
U.S. stocks rallied on Wednesday morning as investors widely anticipate the Federal Reserve will make an historic decision later in the day to increase interest rates.
The move would represent a major vote of confidence in the American economy’s recovery from the Great Recession, which caused the Fed to slash rates to zero for the first time ever.
The Dow was up as much as 165 points in early trading, though it has since given up the early gains and was only about 40 points in more recent trading. The S&P 500 and the Nasdaq rallied 0.4%. It’s a sign that Wall Street is ready for the Fed to move when it announces its decision at 2 p.m. ET.
A rate hike, the first since 2006, would remove deep uncertainty that has been hovering over Wall Street for months.
“There will be this sense of relief that a big overhang/albatross has been lifted,” Michael Block, chief strategist at Rhino Trading, wrote in a note to clients.
But recent junk bond freakout is still a worry
However, stocks could tumble if recent turbulence in financial markets — especially in the junk bond market — causes the Fed to delay a move like it did in September. That would reinforce concerns about the strength of the U.S. economy.
“Should the Fed surprise markets and not hike (not our expectation, but not impossible) expect major volatility, as markets struggle to digest the implications. This is a risk that you need to be aware of,” Bespoke Investment Group wrote in a note to clients.
Assuming the Fed doesn’t shock the market with a further delay, the real key will be how the central bank telegraphs future rate increases. If the Fed signals a very patient approach going forward, it could further boost sentiment on Wall Street. That would lower the chances that aggressive policy could kill the economic recovery.
Fed chief Janet Yellen will have a great opportunity to set expectations when she fields questions from reporters at 2:30 p.m. Watch for how many times she uses the word “gradual,” or something similar.
Stocks are also getting an assist from the junk bond market, which is rebounding after a recent scare. Exchange-traded funds that track the high-yield market, including the SPDR Barclays High Yield Bond ETF, rose modestly on Wednesday.
Oil’s recent volatility also looms large
The junk bond fears are exacerbated by the crash in oil prices, which has caused a wave of energy defaults. Oil dropped 2% on Wednesday to around $36.50 a barrel.
Junk bond concerns have also risen following the implosion of a mutual fund run by Third Avenue that invested in risky distressed debt.
Bonds prepare for higher yields
The far safer market for U.S. government debt is also bracing for the Fed decision. The yield on the 10-year Treasury note, the benchmark rate for debt, rose to 2.29% from 2.27% on Tuesday.
Shorter-duration bonds are more likely to experience a jolt from a rate hike. The one-month Treasury-bill yield rose to 0.22% on Wednesday, up from slightly negative rates as recently as October. It was highest level since 2009.
Will dollar strengthen even more?
After a terrific 2015, the U.S. dollar didn’t move much ahead of the Fed decision. The euro was changing hands at about $1.09. That’s a dramatic decline from $1.25 a year ago, but better than $1.06 just last month.
The relatively strong U.S. economy along with the anticipation of higher interest rates has allowed the dollar to strengthen significantly against rival currencies this year. The question is: will the dollar keep gaining against other currencies once rates go higher?